How price benchmarks work Flashcards
Why does the commodities markets make such heavy use of benchmarks in their day-to-day business?
1) physical commodity deals vary greatly in terms of specifications. Deals can be either for import or export, while the size, quality, delivery, timing and payment terms all vary tremendously. If the price of every deal had to be negotiated from scratch, it would be very time consuming for the traders involved. Market participants prefer to just negotiate the cost of the difference between the general and specific
2) the volatility of most commodity prices makes it extremely difficult to predict. traders would never agree. Instead they will agree on a benchmark index that will broadly capture price changes. The traders will then focus on the size of the premium or discount to this index.
If an Indonesian importer wants to buy a cargo of gasoline from a Singaporean trading house in one month’s time, what are the two options they have for how to price the deal?
1) agree an overall price in US dollars for the cargo. a “flat price deal” (not a common way of doing it) spend a lot of time debating whether prices will fall or rise.
2) link the deal to a benchmark, e.g published assessment by platts, using the average of a number of daily assessments as the index
what is a flat price deal?
when two sides agree an overall price in US dollars , debathing between themselves what prices will do
Over how many assessments would sides take an average?
for Asian gasoline: 5 days
for asian crude oil: a month
give an example of benchmarks used throughout the supply chain
the singaporean trading house would have acquired the cargo from a refiner at a price from platt’s assessments, before selling it to the importer
what is basis risk?
the additional risk by using different benchmarks
what does the benchmark system ensure both sides can do?
ensures both sides can focus on the element of the price that they can control (the premium / discount) ad not on what they can’t (the flat price)
how would counterparties hedge themselves?
they can use derivatives to hedge against adverse moves in the underlying flat price by trading swaps or futures that also settle against the benchmark
What are indexes shorthand against?
they reduce friction in negotiations as both sides take on equal amounts of risk as both are exposed to the same index
What is professional and financial POV for our benchmark being used?
professionally, it means the industry trusts out assessments to be an independent arbiter of a contract price.
financially it means both parties have to subscribe to our data
Why is “first mover advantage” so important?
In benchmark and for PRAs its rare for the industry to switch from one PRA benchmark to the other
Why might an industry favour a PRA?
1) first mover advantage
2) they feel benchmark methodology is more representative/ better for compliance purposes
3) availability of related derivative markets
what is “the availability of a derivate market when picking a PRA?
participants will want to hedge their price exposure to a PRA by taking the opposite position in the derivatives market , they need to know that there are also liquid swaps or futures available for any specific benchmark
What s the most competitive commodity sector for PRAs?
energy market
who is a pioneer among PRAs?
PLatts is the benchmark in most energy markets
